Why the Hot Money's on Cheaper Oil

After months of betting on an increase in oil prices, some speculators now see a new downward trend
OPEC's decision not to boost output and a U.S. report of a drop in inventories helped support oil prices only temporarily. Getty Images

Phil Flynn has learned to be light on his feet. A steady dose of caffeine helps; he drinks up to two pots a day, beginning with his 2:30 a.m. wakeup to check in with European markets. But then quick reflexes are a requirement for any oil trader these days.

That's because in today's oil market, change is the only constant. The latest twist came on Dec. 5, when OPEC announced at its meeting in Abu Dhabi that it would not increase production. That pushed prices toward $90 per barrel in overnight trading. Further bolstering prices was a U.S. government report that oil inventories had dropped by a surprising 8 million barrels the week ending Nov. 30 from the week prior, sending prices as high as $90.35 on the New York Mercantile Exchange (NMX) in morning trading. But the increase was only momentary, and within a couple of hours, prices were falling again. That move tracked the downward trend of the past week, as growing fears of a U.S. recession and speculation OPEC would boost production had helped push oil down more than $10, closing on Dec. 4 at $88.32 per barrel on the Nymex.

Flynn, an analyst and vice-president at brokerage firm Alaron Futures & Options in Chicago and a 24-year veteran of the industry, has long been an outspoken oil bull. He was among the first to predict that crude oil prices would top $30 a barrel in 2000 and close in on $40 in 2004. Just a month ago, when oil closed at $96.46 on Nov. 7, Flynn was ecstatic: "This should be a day of celebration!" he said. "High oil prices are a sign of a strong global and U.S. economy. I'm very bullish—scary bullish."

Speculators Concern OPEC

But a lot of scary things have happened in the past month, most notably worries about a spreading credit crunch. Now even Flynn doesn't expect the latest price lift to last. "I'm bearish for the first time in years," says Flynn. "Make no mistake: The trend will be down unless we get a major event to change the outlook. If we get back to the mid-90s, get ready to bail. The sell-off is far from over."

Stocks of the major oil companies often reflect the rise and fall of oil, so it's no surprise that share prices have dipped over the past month. But on Dec. 5, share prices for ExxonMobil (XOM), Chevron (CVX), and ConocoPhillips (COP) all rose on the news of tighter oil inventories, and as positive economic news lifted the overall stock market.

The hair-trigger impulses of traders like Flynn play a larger role than ever in the oil market (BusinessWeek.com, 1/16/07). Indeed, in issuing their Dec. 5 statement, OPEC officials expressed concern about the role of speculators in setting prices and said they would act in the future to keep markets stable. There are now 595 hedge funds that engage in at least some energy trading, more than triple the 180 funds involved just three years ago, according to Peter Fusaro, co-founder of the Energy Hedge Fund Center, which tracks commodities-based hedge funds. Fusaro estimates the assets involved in such trading total more than $200 billion, up more than 60% from the beginning of 2007.

While five years ago oil brokers could hold steady long or short positions on oil—predicting a price rise or fall—they now construct complex transactions to react to daily and intraday fluctuations. "Through the 1990s the landscape was much simpler; prices were up or they were down," says Flynn. "More volatility makes things more difficult but not impossible. You've got to be that much more aggressive."

Innovative Trading

Flynn is an example of how traders have been forced to innovate. He is removing some long-term positions that assumed prices would rise. Now he's using tools such as a "three-way trade" to profit from the downward momentum while also insuring these trades against the possibility of a sudden spike. "Even when we're headed one direction, you have to acknowledge the volatility," he says. "No one can predict where this market goes intraday; you have to learn how to play it and not get hammered."

A three-way trade can let Flynn bet on the upside or downside while maintaining a hedge in case of sudden shifts. He used them sparingly in the past, but so far this year about 40% of his transactions have been structured this way. Here's how a three-way trade works: Each trade consists of a futures contract combined with a pair of options—a call and a put. A futures contract is an agreement to buy oil at a certain price today and collect it at a later date, regardless of its future value. Options are contracts that allow the buyer the right to buy (a "call") or sell (a "put") an asset at an agreed-upon price during a specified time frame. Traders use puts as protection when they expect a price to drop, and buy calls at a low price when they expect the price to go up.

How Flynn structures the three-way trade depends on whether oil seems headed up or down. When oil prices are on the rise, he buys a futures contract, sells a call, and buys a put. But since oil prices have marched downward in the past three weeks, he has inverted the formula to instead sell futures contracts, buy calls, and sell puts.

With the latest OPEC news, Flynn reverted to the buy-sell-buy combination. That lets Alaron take advantage of the market's momentum—however fleeting it might turn out to be.

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